PFFAP-PYP-23-0920-What are ETFs
Voiceover: [00:00:00] This show is for educational purposes only and is not personalized advice. Consult your tax advisor before taking action. All investments involve risk of loss. Past performance is no guarantee of future results. Read show notes for full disclosure.
Welcome to the Physician Family Financial Advisors podcast, where. Physician moms and dads like you can turn today's worries about taxes and investing into all the money you need for retirement and college.
Nate: Hello, physician moms and dads. I am Nate Renike, certified financial planner and primary advisor here at Physician Family Financial
Ben: Advisors.
And I'm Ben Utley, certified financial planner and service team leader. Today,
Nate: we are going to talk about a physician investing basic by answering the question, what are exchange traded funds? We're also going to address the question of whether or not physicians should be using ETFs. So Ben, let's start by just describing what an ETF is.
So what are
Ben: they? Okay. [00:01:00] Just the very simple is it's, it's a mutual fund that trades like a stock. So if you don't know what a mutual fund is and you've never traded stocks, that's not super helpful. So I'm sure we should, we should drill down here pretty quick. Yeah.
Nate: Okay. Well, I got some questions for you then.
So let's, but trades like a stock, I hear that all the time and I want to ask this later, but like, what does that mean? And all that. But first, can you, can you, for someone who doesn't, that wouldn't be a good explanation for them. Maybe could you tell us like the history of an ETF and, And put it in plain language.
Ben: Let me, let me start by breaking down mutual fund in, uh, 60 seconds or less, hopefully. Okay. So let's imagine that, that you and a couple of friends want to buy a bunch of stocks. You don't want to buy one stock. You want to buy a bunch of stocks together. And to, to make it more economical, you go in together and everybody puts in like, I don't know.
Uh, 50, [00:02:00] 000 and you get 20 friends and so you got a million bucks. Okay. And then you put it all in one account and then you buy, you know, a hundred different companies, right? And each one of those might come with a transaction costs or a commission, but you're splitting that instead of having 20 trades in each of those hundred shares, you're having, uh, you know, one trade in each of those hundred shares.
And so everything is, is. pooled together. So it's a pooled investment, all right? Uh, and at the end of the day, instead of just owning a big batch of this, everyone gets a share in that pool. Okay? And that's how mutual fund shares work. What we call open end or traditional garden variety mutual funds, which have been around since the 20s.
Believe it or not. Mutual funds have been with us for almost 100 years. So that's how a mutual fund works. Now, the way stocks trade is, uh, in the middle of the day while the market's open, you can go enter an order and you can say, I want to buy 100 shares of XYZ. You click the submit button and it goes out onto the magical exchange where the magical [00:03:00] elves drag it around.
They figure out who's going to give you those shares and they give you their money, right? So that's, that's high level trades like a stock. So it's a mutual fund. That trade like a stock is an exchange traded fund. So that, uh, very similar to securities that have been around for almost a hundred years.
And, and beyond that, we'll, we'll have to break it down. So do you, do you want to know kind of the history now?
Nate: Well, um, yes. And then later I want to ask what the trade like a stock, like what's the benefit of that. But real quick, like, um, how did exchange traded funds get started? Like, why did they branch off from mutual funds?
Ben: Okay. Um, I'm not sure why. They, they started, but I can tell you how they got started. So let me, let me draw a real life example. So let's say that, uh, I'm a, I'm a grain farmer. I grow wheat. Okay. And I've got, I've got all these thousands of bushels of wheat that I'm delivering to the market. So I deliver them [00:04:00] to a grain silo someplace.
And rather than selling them directly to all the people in the in the market, I want to sell them to somebody else. So I put them in a grain silo, my grain silo, and then somebody else says, Hey, I want all that wheat. So then we back the truck up and load all the grain onto the truck, drive the truck a thousand miles to their barn.
And once it gets to their barn, we dump it off and and they give me payment. So like the delivery versus payment could take weeks. And then I get the cash, I cash the check, and then it's done. That's laborious when grade trains, excuse me, that's laborious when grain trades, not only every week, not only every day, but minute by minute.
Right? That's a lot of trucks driving around. So some really wise folks got together and said, Hey, let's, um, let's find this grain silo of trust, kind of like a grain bank, if you will. Okay. And the farmers can put their grain in there when they, when they make a deposit of that grain, we'll give them a receipt that represents [00:05:00] ownership of that grain.
Okay, you could kind of call it like a depository receipt and whoever has that receipt has the right to withdraw all of the grain and do whatever they want to with it. So now, rather than trading grain itself, you can trade the receipt for the grain, right? Because the receipt is just as good as having the grain in hand.
So that's how depository receipts came along. We've had depository receipts for a long time. Then there was a company named Standard Poor's, which a lot of people have heard about, and what they decided to do was, hey, instead of it being grain, Let's make it shares of U. S. stocks. In fact, we'll make it shares of the 500 largest companies in the United States.
The Standard Poor's 500. And rather than it being a grain silo, it'll be a bank account. And what'll happen is the, uh, we'll, we'll put our shares on deposit with the bank. We'll, we'll have a representative 500 shares. And then that'll create a depository receipt. And then whoever has, [00:06:00] whoever possesses that receipt can go in and claim the stocks.
Okay, and so then the receipts change hands. So because it was Standard Poor's depository receipt, that spells out S P D R, kind of like the word spider. And so if you've ever seen disclosures for them, it has a little spider logo on top of the S P D R. And so the original ETF shares branding was called Spiders, and the first ETF shares that were issued were traded on the symbol SPY, which is kind of cute and short for spider.
And so, SPY is a, is the ETF, the original ETF that represents ownership in the 500 largest companies in the United States. So that was, that was the first one and it was issued back in 1991. So this investment technology was, has been with us for over 30 years. Okay. So
Nate: I'm sure in 1991, 500 shares of different companies or 500 different companies was extremely [00:07:00] diversified.
But, uh, fast forward to today, how have ETF sort of changed from that first ETF that was created?
Ben: Well, yeah, so now there are at least hundreds, if not thousands of exchange traded funds. Right. So initially we had the Standard Poor's 500 and then we had the Dow Diamonds, Dow Jones Industrial Average, DIA, first four, three letters of diamonds.
Okay. Then we also had what they call the cubes, which is QQQ, which is the NASDAQ index trading shares. Um, and that's, those are kind of the first, the big three. Uh, and then we got. Versions of sectors, so you could trade the tech sector. You could trade the finance sector. You could trade utility sector So since then it's just been an explosion of exchange traded funds.
So that all that stuff is stock now There are bond ETFs And there are just as many different kinds of bond ETFs as there are kinds of bonds. You can drop by [00:08:00] municipal bond ETFs, which are tax exempt, government bond ETFs, junk bonds, long term, short term, high risk, low risk. Uh, there are even versions of exchange traded funds that go the opposite direction as the market.
So when the market goes up, these go down, and people are using that as a form of short. There are some that are amplified, where when the market moves up a dollar, these things move up by two or three or ten dollars. So, it just gets exotic from there. There's international ETFs where you can buy literally all the companies outside the United States.
In fact, you can buy all the companies in the world. With one exchange traded fund, you can buy, uh, you know, shares of Argentina, if you want, or China or Russia or whatever you want, you can, you know, there's all kinds of different ETFs that are put out by legitimate companies. And there's just thousands of choices and different ways to slice and dice all of the investable markets using exchange traded funds.
Nate: So Ben, when I talk [00:09:00] to new physician investors, they generally come to me and say. That they are fully diversified and many times that means that they have purchased an ETF But usually when we open up their portfolio we see the S& P 500 So while that is an index fund Is that totally diversified and if it's not?
What is?
Ben: Yeah, it's it's not an easy answer to that question. So, you know What I, what I think you're seeing and what I, what I see regularly is someone who's been managing their own investments, which is not a bad idea. And when I look into their portfolio, I see multiple accounts and I see the same security in all those accounts.
And it's typically the S& P 500 index, whether it's an ETF or it's a Vanguard fund or it's a Fidelity fund. Uh, you know, it's, it's S& P 500. So the question I guess is, is that diversified? The answer is kind of. So if [00:10:00] you're going to be a U. S. stock investor, then the S& P 500 is diversified. Uh, you get exposure to all of the sectors of the U.
S. economy, from finance to technology, to utilities, uh, you know, all that. You get all of it. But you could ask the question, like, okay, so are you really diversified if you just invest in the United States? And this is a question without an answer. You're not going to get any two people that agree on that because we have what's known as home side bias, which is where Americans and we like American stuff.
And so we're going to invest in U. S. stocks. But there's there's an entire investable universe out there composed of Developed foreign markets, so you know France England Italy Australia Japan, you know those those guys and then you have the emerging markets, you know Mexico China Russia Brazil India all those countries and There's nothing to say that U.
S. [00:11:00] stocks should perform better than the stocks of those countries. You know, there's nothing to say that Hershey's should perform better than Cadbury, right? Because it's all chocolate. So there have been times when one of those markets does better than other markets. A lot of it has to do with the flow of trade and has to do with currency exchange rates and all that good stuff.
But if you want to be really diversified, then you own a little bit of all that good stuff. And the ratio varies, you know, how you put your portfolio together varies. But for example, you could buy One index ETF for all the stocks in the U. S., one for all the developing markets, and one for all the, uh, Developed foreign markets.
Okay, so then it's like, okay, so I'm diversified, right? Well, you have everything in stocks at that point. So then you have to ask the question, am I balanced? Okay, and so the way that we take a fully risky portfolio, which is all stocks, and we walk back the risk a little bit or a lot, is to balance that out [00:12:00] with bonds.
Okay, so bonds tend to be our steady eddies. They tend to generate income, uh, in most years, except for last year, of course. The value does not fluctuate a whole lot, and they tend to stabilize the overall portfolio. So, uh, you know, what kind of bonds you choose has everything to do with what kind of account you're investing in, whether it's taxable or whether it's an IRA.
Uh, some of it has to do with what part of the country you're located in and what your income tax rates might be there. So there are a variety of ways to invest in bonds. So for, for me, kind of the way that I approach this, which is belt and suspenders. I want to own a slice of all of the stocks in the world that I can invest in, and I want to own a slice of most, if not all, of the bonds in the world that I can invest in, so that, you know, if something bad happens to one stock, or one sector, or one country, or the stock markets collectively, that, you know, I have some protection against that.
And to me, that's the point of [00:13:00] diversification, is to be able to weather, uh, tough times. I
Nate: see. Okay. So, let me get this straight. So, you, most, most folks buying an index fund with 500 companies in it and 500 U. S. companies in it. Right. A more diversified approach would be to buy thousands of companies across the world.
Yes. And an even better way to go about this is to stabilize your portfolio with thousands of different types of bonds, bond funds, throughout the world. That's
Ben: correct. Okay.
Nate: So, can you do that with
Ben: mutual funds? You can do that with mutual funds. And because you can do it with mutual funds, you can do it with exchange traded funds, which are, in fact, mutual funds.
Okay.
Nate: So, so why do it with ETFs versus
Ben: mutual funds? ETFs, um, I don't want to get down in the weeds of it, but if, if we had [00:14:00] to re, reinvent mutual funds today. We would probably not invent the old fashioned kind of mutual funds for the reason that they lack some tax efficiency. So, Um, for example, uh, you know, back to the analogy of you and a bunch of friends pooling your money.
All right. So let's say that five of those 20 friends want to, want to back out of the deal. They're like, you know, we need to go buy cars. I want to sell my mutual fund shares. So they sell their mutual fund shares and they want to get cashed out. Right? So we have to pay them their cash. Only way we can pay their cash is to sell some of the stocks that are inside of our mutual fund.
And when we sell the stocks inside the mutual fund, we're going to realize capital gains. So, there's going to be a capital gain that's all pent up inside that mutual fund. And so, our buddies take their cash, and we're left with what remains of our shares, but we also have these nasty capital gains. And at least once a year, those capital gains, under the tax law, have to be paid out to the remaining [00:15:00] shareholders, which means that we, as the remaining shareholders, are going to bear a portion of the tax liability of the shareholders who are no longer there.
And this happens in the real world to great degrees and to tiny degrees, depending on how the mutual fund is managed, how large it is, and what the cash flows in and out of that fund are throughout the course of the years. It's particularly happens in actively managed mutual funds, less so than an index funds.
But even at a house as well regarded as Vanguard, they had a suit over this several years ago, uh, where You know, some of the current investors were left with capital gains as a result of a change in the funds, and there's a lawsuit over it. So ETS don't work that way because they trade like a stock.
Rather than like, uh, uh, you know, people entering and leaving a pool, you know, when you're ready to cash out of your, your index ETF, you simply sell it to someone else. And that's [00:16:00] done through the markets, through brokerage accounts. You never see that part. But basically, there's somebody else out there who's got cash ready to go, and they're going to buy those shares off the exchange after you sold those shares onto the exchange.
So, the, the original pool of investments remains intact. It keeps its integrity and the capital gains that are there stay in there because they're, they're, they're not selling inside that fund. It's a, uh, is it nobody, nobody's in the silo stirring the grain to make the dust come up. You know, it's just the standard portion of parts of the depository receipt changes hands for one person to the next.
I see. So they're, they're inherently more tax efficient. And so that's, you know, more tax efficiency is good for doctors who not only pay capital gains tax at the, at the highest capital gains tax rate, they typically pay a surtax on top of that of another 3. 8 percent plus, you know, the state income taxes in some states.
I see. Okay.
Nate: So they are, [00:17:00] you can be extremely diversified with ETFs. Yes, they are tax efficient, which for physicians, um, this is in your taxable account, so you won't have a big tax bill, rather than some mutual funds where you might experience that. And we haven't said this, but they're also inexpensive to use.
Ben: Yeah, they're inexpensive to use and to operate. So, you know, back in our pool of friends, right? One of us has got to run an account. One of us has got to get everybody together. You know, ostensibly there'd be attorneys and accountants and all those folks involved. So all mutual funds, whether they're ETFs or traditional open and mutual funds, have expenses.
And that expense is expressed as a percentage. It's an operating expense ratio. So it's expenses over the total value of the fund. And, you know, back in the day when I, when I started in the industry, those operating expenses could be as much as 2 percent of the fund. And nowadays, you know, in exchange traded funds, [00:18:00] we're seeing that like 0.
02%, right? So just a tiny little fraction, literally, you know, uh, A thousand times less. So they're, they're very inexpensive because they're so large. They're able to spread the expenses of maintaining these funds over so many people that, you know, they're, they're just almost free. I mean, to put it in perspective, um, 0.
01 percent is what we call one basis point. And one basis point on a million dollars is a hundred bucks. Yeah. Right. Right. Right. Right. Given what they do inside these funds and given all the technology and engineering that goes into them, I mean, that's really, really cheap for holding something. I mean, that's, uh, you know, we're talking before the show with Russ that that's, you know, eight bucks a month, seven bucks a month is like about 100 a year.
And that's if you only have one Starbucks latte once a month, right? So, I mean, this is, we're talking less than pizza money here, [00:19:00] right? So, even if you've got five or six million dollars invested in ETFs, I mean, you still are less cost than it is to take your friends out once a month. Okay,
Nate: that makes sense.
Yeah. There's got to be something some pitfall of ETFs and and from all the things that you've said Essentially, it sounds like ETFs to an investor physician investor. This is like candy. This is this is a great option Yeah, it's something that you said that I still Hear from physicians all the time as an issue if they're doing their own investing is there's just too many options Hundreds and hundreds of options.
Yeah, how does a physician navigate all
Ben: those options? It's a good question. Um, I'm not sure. Uh, when I, when I look at portfolios of people who, who've handled their own money, typically, like I said before, you know, we see one ETF, it's all, it's all in the S and P [00:20:00] 500 and you know, that's, that's been great for the last 20 or 30 years, whether or not it will remain the same going forward has a lot to do with how Congress treats our nation.
Um, so. Um, I mean, that's, that is the thing that I see people doing, um, you know, in house will typically build a portfolio out of at least four exchange traded funds. So one for each part of the stock world, right? And at least one bond fund. So you can actually go simpler than that. You can buy actually, uh, Vanguard, a number of companies have what they call the total world stock index.
Where you can buy all the investable markets in the world in one ETF. I don't see that very often, but it's possible. And, uh, then you can, I believe there are like world bond ETFs. So you can buy most of the investable bonds in the world. So that'd be U. S. because we're one of the biggest debtors. Uh, foreign as well as developing markets, which would be a tiny slice of that.
So conceivably you could have [00:21:00] everything in two ETFs. So, um, it's not uncommon to see people buy a US ETF with foreign ETF to put things together. So, you know, because these ETFs slice and dice the market into little pieces, you can, you can recompose it. If you say, well, I want emerging market exposure, but I don't want China.
You can do that. You know, uh, or, you know, I've got, I've got these U. S. technology stocks that I, you know, uh, got my divorce from my, my ex technology husband and I have a low basis in them. If I sell them, I'll pay a lot of, a lot of gains. So I want diversified U. S. exposure. So then you buy the, the other sectors to build around those stocks and then you're fully diversified.
You haven't realized any capital gains. So they're just, um, I would look at ETFs as building blocks. That you can use to solve various investment problems, but most people don't have complex investment problems to solve. So for most people, just a small [00:22:00] number of ETFs. We'll, we'll solve the problem. And, you know, um, big companies in this area are like, Vanguard has ETFs.
Uh, Schwab has ETFs, uh, iShares has ETFs, uh, dimensional Funds has ETFs. There are dozens of companies that have them, but there's just a handful of companies that have very well run, low cost, tax efficient ETFs that, um, we typically build portfolios from.
Nate: I see. Yeah. So what I'm hearing you say is, is there's a decision to be made between, or a balance to strike between control, what exactly and how much exactly do you want of each sector versus simplicity.
Yeah, exactly. And most physicians right out of the gate, uh, they choose simplicity, which is actually good. Uh, simplicity is good. You don't want to get your hands on this too much, but there is a level of control that can be. Utilized and it's [00:23:00] just finding that balance which Takes some
Ben: expertise. Well, I want to talk about the control aspect of this and okay So, um, I think that the downside of exchange traded funds for physician investors has to do with the investor themselves Physician investors, I would count myself in this category as well So because they trade like stocks You have to first put money in the account, cash in the account.
Once the cash is in the account, then you have to actually go in and place a trade. And so, you know, the thought process that goes through my mind as I place a trade is like, is now a good time? And how much should I buy? Should I put all my cash in it? Should I put a little bit in it? Should I drip it in over time?
Gosh, this, uh, this fund looks good, but I wonder if there's something that's a little bit better than this. And then I start poking around and then you just go off in the weeds of kind of, uh, investor hysteria. Sometimes you get analysis paralysis. Uh, for me personally, the best investments I've made is where I can mail a check.
And have it get invested, maybe make this decision one [00:24:00] time and have that decision stay in place so I can stay on course. Um, up until recently, I've not been an ETF investor. I prefer to open in mutual funds because I could fire off a check and know that that money was going to get invested, right? And that's why I didn't use ETFs because it was, it's just too much, uh, There's too much second guessing.
I mean, even for me as a financial advisor, the problem is I probably know way too much, right? It'd be like taking your kid to a pediatrician if you're a pediatrician. So, um, You know, now we use a, a company that automates the purchase of investments. It's known as betterment and, uh, you know, I was one of the, one of our first people to open a betterment account.
I love it because I can just, you know, transfer cash in and it automatically gets invested and diversified according to the lineup that we've chosen. And it, it buys the right ETS at the right time. And, uh, so I, I feel really comfortable with that because it's, it's fire and forget it's, you don't get to overthink it.
You just. Decide whether or not you're gonna put the money to work. So, uh, [00:25:00] you know, trades like a stock is the, is the place where an individual investor could get in trouble with ETS. Right. You
Nate: kind of have to know how to trade stocks or know, know yourself to know that you will go in there and do it.
Yeah. I'm the same. I, I send my money to betterment every month and it's already preset in there. So this reminds me of kind of the saying that, um, at least for physicians with physicians, most investment strategies will work if you can stick with them. Right. And that's a big if. People think it's not a big if, but with market turmoil, anytime there is some, uh, people get a little squirrely and, uh, they start making, uh, ill advised decisions.
Yeah. So, um, I think we've talked a lot about, ETFs and kind of the, the structure of them. But is there anything that you think [00:26:00] investors just don't get about them that you might want them to know?
Ben: Well, I think mutual funds in general are not the easiest thing to understand just right out of the box. Um, so that means that ETFs are not super easy to understand right out of the box.
Uh, it seems like a lot of topics where if you sit down to self educate, you get a lot of pouring through the internet to read or books to read. Um, but you know, like any topic, if I want to know about a topic, I try to find somebody who has already been there and done that that can explain it in a sentence or two and really help me grok on the topic and then I can go back and read.
So I would just say that, um, you know, the thing about ETFs is they are so cheap. You know, we already talked to that. You can have a million dollars worth of ETFs for less than the cost of dinner out. Um, there's, there's nobody there to sell the ETFs, right? So there's nobody to talk to about purchasing the ETF.
So that means that you're going to [00:27:00] either be talking to like a stockbroker or an advisor. And the stockbrokers don't make money on these either. Uh, Charles Schwab and Vanguard, uh, came up with pricing where, you know, you don't pay to trade stocks and you don't pay to trade ETFs either. So the commission on those trades is literally zero.
And as a result, they don't have a whole lot of incentive to talk with you about these. And maybe that's a good thing. Maybe it's a bad thing. But the fact of the matter is, there's just no one to discuss it with you. So I would say that that's, that's difficult. You know, it's like going to the grocery store.
If you, if you'd never bought things at the grocery store before, you kind of want to know what they are. Um, if I go into my local ethnic grocery store, I love to go on adventure. You know, there's stuff on the shelf where I can barely read the shelf tag. It's, I see people buying it. I don't know how you use it.
I don't know how you put it together. What are the things you put in a meal? And I would just love to pull those folks aside and say, Hey, I want to eat this food that looks really good. How do I do it? You know, do I bake it? Do I, you [00:28:00] know, do I fry it? Do I peel it first? Do I eat it whole? And that to me is kind of like ETFs or, uh, you, they can be a little bit like a foreign language and you know, they go together in a certain way.
And if you do it right, then, then you can have a good experience with it. So I think just the fact that they're, uh, The instructions don't come with them. That has a lot to do with it. It's kind of like a lot of other stuff that somebody gives you a dollar. It doesn't have any instructions. Right,
Nate: right.
Yeah. So the big takeaway that I'm getting from this is that ETFs are good for physicians. They're better than traditional mutual funds and they're great for physicians who want to get all the tax breaks they can.
Ben: That's right. That's right. Okay. Yep. So is that all we have today? Yeah. Okay. So that's, that's all for now, folks.
Until next time, remember, you're not just making a living, you're making a life.
Voiceover: Thank you for listening to the Physician Family [00:29:00] Financial Advisors podcast. Are you getting all the tax breaks you really deserve? To find out, get your copy of the Overtaxed Doctor's Retirement Investing Checklist, available at physicianfamily.
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